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Should Government consider a generalised stay of enforcement of financial covenants? Expert Comment

Dr Stephen Connelly of Warwick Law School comments:-

“Large and medium size enterprises tend to fund their operations through debt and equity, and commonly that debt is provided under a credit facilities agreement. These contracts are fairly standardised and commonly contain financial covenants which require the corporate borrowers to maintain a certain ratio of earnings to interest payment requirements, and a certain net worth in relation to the debt owed by that business. In normal circumstances these contractual stipulations are triggered by microeconomic failings of the corporate and act as a warning light for cautious lenders.

"In abnormal conditions, such as today and indeed the Credit Crunch, these same financial covenants can be triggered by macroeconomic collapse which is not the fault of the borrower. For example if an airline’s earnings evaporate because of a ban on transnational travel (or fear of one), that airline will be breaching its financial covenants within the quarter. The result: our corporate is in default and the banks have the right to accelerate loans, demand payment, and enforce any security. The threat of imminent destruction places Main St in a perilously weak position compared to Wall St. when negotiating waivers of the breach and possible restructuring of debt. Banks may threaten to force a corporate into insolvency, or enforce security over shares so as to rid themselves of the existing management team.

"This macroeconomic triggering of financial covenants led to extensive destruction of value and goodwill in 2008, exemplified most infamously by Royal Bank of Scotland’s Global Restructuring Group. Given the widespread use and standardisation of financial covenants and the capacity for their misuse in current circumstances, I would urge Government and the Bank of England to consider measures to lessen the pressure on corporates to satisfy financial covenants, perhaps by means of a generalised stay of enforcement of these financial obligations – similar to that available in a bank resolution – as part of a broad intervention to support the economy."

17 March 2020

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